© stephen hall, imperial college londonpage 1 economic environment lecture 1 joint honours 2003/4...

© Stephen Hall, Imperial College London

Economic Environment

Lecture 1

Joint Honours 2003/4

Professor Stephen Hall

The Business School

Imperial College London



• Introduction & Overview• Macroeconomics is the study of economic aggregates and

their dynamics. Examples include the inflation rate, gross domestic product (GDP), the unemployment rate, and so on.

• As we will demonstrate, the state of the macro economy and government economic policy are interrelated.

• In this course, we wish eventually to assume the point of view of (a manager of) a single business firm, whose task it is to – understand how the economy functions– anticipate government policies in light of the state of the economy– anticipate how those policies will affect the business climate in – general, and his/her business in particular, and finally– make managerial decisions today based upon these anticipations



• This viewpoint is best depicted as follows:

Government Macro Economy

Firms


• The preceding figure provides an appropriate perspective from which to approach the course material.

• The preceding figure is not, however, the best way of understanding economics. A business firm is itself a part of the macroeconomy, and so should rightly be placed inside the “macroeconomy” box. Moreover, there is also the rest of the world to consider. (Economically speaking, the UK is not an island!) The government has not only (monetary and fiscal) policies to deal directly with the macroeconomy, they also have internationally-oriented policies, and others directed more precisely at individual business firms.



A more comprehensive list of government policies would be:• Fiscal policy: dealing with government spending and taxation• Monetary policy: establishing interest rates and money

supply• Exchange rate policy: dealing with the international value of

the pound sterling• International Trade policy: involving measures taken to affect

the magnitude and direction of international trade• Supply-side policy: designed to directly encourage business

firms to produce more• Prices and incomes policy: introduced to reduce inflation or

support income• Employment policy: designed to protect or create jobs



• A more comprehensive depiction of the firm, its position in the economy, and the effect of economic policies is provided by:


Firm

Oil price shocks, Exchange rate policy, Fiscal policy, Monetary Policy, Trade…

The Business Environment

Domestic

economy

International

Economy


If we were to list government objectives, this would include things like low inflation, high incomes, economic growth, low unemployment, etc. There would also be a long list of “non-economic” objectives like low crime rates, a “fair” income distribution, better education, and so on. We may illustrate the government’s task as follows:

• policy instruments -> policy targets -> ultimate goals

The Economic Problem


Some key issues in macroeconomics

• Inflation– the rate of change of the general price level

• Unemployment– a measure of the number of people looking for work, but

who are without jobs

• Output– real gross national product (GNP) measures total income of

an economy• it is closely related to the economy's total output


More key issues in macroeconomics

• Economic growth– increases in real GNP, an indication of the

expansion of the economy’s total output

• Macroeconomic policy– a variety of policy measures used by the

government to affect the overall performance of the economy


• However ..• The fundamental economic problem is that resources are

limited, so a government and its people cannot have everything they want. Choices must be made. Put another way, everything has an “opportunity cost”.

• Referring back to the previous list of government policies, it is apparent that the policies frequently overlap one another and, implicitly, policy objectives conflict with each other. This is simply a result of the fact that all policies require choices and involve costs.

• The government’s job is to understand the effects of their various policies, i.e., the opportunity costs involved, and to make choices accordingly.



• How to Proceed:

• What we need to do is to develop a model - or several models - of the macroeconomy.

• Because we are dealing with economic aggregates, a

high level of abstraction is required.

• This means that our model will be both simple and highly unrealistic.



Question:

• if a model is simple and unrealistic, is it necessarily a bad model?




• Essentially, we will start with bits and pieces, build a simple model, and then gradually add on to it. Eventually, we will have a model that allows us to understand the interrelationships between the interest rate, inflation, unemployment, government spending, taxation, output, and so on.


One important caveat

• The model we will use is a static model, i.e. dealing only with the present.

• From it, we will make inferences about future economic behavior and government policy.

• Unfortunately, the model is not well equipped to deal with questions regarding long-term economic strategies.

• However, it is a very useful model for understanding short- and medium-term economic problems and, more importantly, for anticipating government policies.

• (Despite all the political rhetoric, governments from all parties and in all western countries re extremely short-sighted; much more so than private businesses!)



• A good way to think about the model is that it is appropriate for understanding economic behavior and government policy within a business cycle, but tells us nothing about the long-run. (Indeed, in some cases, the best short-run policies turn out to be the worst long-run policies!).



The Business Cycle and National Income determination.


Economic Performance

Before introducing the model, it is useful to have some idea of the state and recent history of UK economic performance.

General areas of interest include:

• Economic growth (in output): which was low relative to other western economies until the 1980s.

• Profitability and productivity: which were low relative to other western economies until the 1980s.

• Unemployment: which was relatively high throughout most of the 1980s (and again presently).

• Inflation: which was extremely high in the early- and, again, the late- 1970s, but relatively low throughout most of the 1980s (and especially so presently).

• Balance of payments (i.e. net exports) and the exchange rate: both of which have declined throughout most of the 1980s to present.


Inflation in the UK, 1950-99

0

5

10

15

20

25

30

% p

.a.

Source: Economic Trends Annual Supplement, Labour Market Trends


Inflation in selected European countries

0 1 2 3 4 5

% change 1998 compared with 1997

Greece

Portugal

Italy

Spain

UK

Finland

EU

Belgium

France

Germany


Inflation in UK, USA and Germany

0

2

4

6

8

10

12

14

16

% p

.a.

1960-73 1973-81 1981-90 1990-98

UK USA Germany


Unemployment in the UK, 1950-99

0

2

4

6

8

10

12

14

% p

.a.

Source: Economic Trends Annual Supplement, Labour Market Trends


Unemploymentin selected European countries

0 5 10 15 20

% unemployment (ILO measure) 1998

Greece

Portugal

Italy

Spain

UK

Finland

EU

Belgium

France

Germany


Unemploymentin UK, USA and Germany

0

2

4

6

8

10

% p

.a.

1960-73 1973-81 1981-90 1990-98

UK USA Germany


Economic growthin UK, USA and Germany

0

1

2

3

4

5

% p

.a.

1960-73 1973-81 1981-90 1990-98

UK USA Germany


Economic Sectors and Flows

To understand how an economy functions, we need a model. Regardless of which of several models we choose, the model must:

• Define various “sectors” of the economy; and• Characterise economic activity as flows of “real”

commodities (or, alternatively, financial capital) between these sectors.


Sectors

• Households: who provide the “factors of production” to business firms and ultimately (in one form of another) receive all of what the economy produces.

• Business firms: who transform inputs (factors of production) into output.

• Government: which functions somewhat like a firm in that it uses inputs and produces output; but it has different objectives and faces different constraints than do firms.

• Financial services: which essentially facilitate the flow of financial capital between sectors, but do not use or consume “real” resources.

• Foreigners: who import into, and export from, the economy.


The circular flow of income, expenditure and output

Y

Households Firms

C + I

I

CS


Government in the circular flow

Y

C + I + G

I

CS

Households FirmsGovernment

C + I + G - Te

Te

G

B - Td

Y + B - Td


Measuring Economic Activity

• To measure the total amount of economic activity, one must find an appropriate place on the flow diagram (i.e. one in which all economic activity must pass through) and measure the amount of economic activity that does in fact pass through.



There are three such places at which economic activity can be measured. The measurement of economic activity is done differently - and has a different name - depending upon which such place is chosen.

• Output method: (at the “firm” box at left) measures the value of final output produced by firms.

• Income method: (at the “households” box at right) measures the value of all income received by households.

• Expenditure method: (at the “market for goods and services” box at top) measures the total expenditure by various sectors on the economy’s output.



• All of these methods should lead to the same total amount of economic activity. Therefore, the terms “output” (GNP), “income” (GNI), and “expenditure” (GNE) are used interchangeably.

• The actual measurement of a country’s economic activity is documented in the “national income account”.


UK National Income 1988

• The Handout has a detailed picture of the UK national accounts as a table.

• This shows all the adjustments necessary to make

• Income=Output=expenditure


Problems in Calculating National Income

From the flow chart, it would seem straight-forward to calculate national income. However, there are three main complications:• Depreciation: Over time, firms’ capital stock (i.e. machinery) loses

value. This lost value must be accounted for.

GNP - depreciation = Net National Product (NNP)

• Prices: The expenditure method uses the market prices paid for goods and services, which is net of indirect taxes (like VAT) and subsidies. The other methods use factor costs, which are exclusive of taxes and subsidies. Therefore, GNE must be adjusted as follows:

GNE (factor cost) = GNE (at market prices) - taxes + subsidies

• Foreign firms: Do we wish to measure domestic economic activity (which would include foreign firms producing in the UK, but exclude British firms producing abroad), or national economic activity (which would include British firms producing abroad, but exclude foreign firms producing in the UK)?



Gross Domestic Product (GDP) vs GNP:

GDP = GNP - net property income from abroad (NYA)


National income accounting: a summary

GNP(andGNI)

atmarketprices

GDPat

marketprices

NYA

C

X - Z

I

NYA

G

NNPat basicprices

Deprec'n

Nationalincome

Indirect taxes

Wagesand

salaries

Self-employment

Profits,rents


What GNP does and does not measure

• Some care is needed:– to distinguish between real and nominal

measurements– to take account of population changes– to remember that GNP is not a comprehensive

measure of everything that contributes to economic welfare


Leakages and Injections

From the flow diagram, we can see that total household expenditure (consumption (C) + saving (S) + taxes (T) + imports (M)) must equal the total expenditure on goods and services (consumption (C) + investment (I) + government spending (G) + (X))

C + S + T + M = C + I + G + X

As the C’s cancel,

S + T + M = I + G + X

From the household income point of view, this is interpreted as

“leakages” = “injections”


Crowding Out

The equation above can be re-written as:

S - (X - M) = I + (G - T)

where

- (X - M) is minus net exports; identically net

imports,

(G - T) is government borrowing (the PSBR)


Crowding Out

Ignoring net exports (which are frequently close to zero), the equality (actually, an identity!) states thatprivate saving = private investment + governmentborrowing

To ensure sufficient private investment (which is the engine of long-term economic growth), an economy must have considerable private saving and little government borrowing. Government borrowing which takes away from private investment is known as “crowding out”.


Crowding Out

Injections

Investment Government Exports

Savings Taxes Imports

Leakages


A Note on Where We Are Heading

Presently, we will begin introducing simple models of the economy, and gradually build upon them to obtain a workable, comprehensive model of the macroeconomy. The steps we will eventually take are:

• A focus on the commodities market. We will first look at demand-side models of output determination, with no concern for prices of any kind.

• The introduction of the interest rate. This extra variable means that we can solve only for output/interest rate combinations, which satisfy commodity market equilibrium. (The IS-Curve).

• The introduction of money supply (and the banking system) and money demand. WE show that money-market equilibrium is actually a set of output/interest rate combinations. (The LM-Curve).

• We argue that both the commodities market and the money market must be in equilibrium. (Essentially, this involves solving this IS and LM curves simultaneously for equilibrium values of output and interest rate). This gives us a unique macroeconomics equilibrium. (The IS-LM model).


Where we are heading……..

• The introduction of an over-all price level. We show that, through the money market, the IS-LM model implies an inverse relationship between the price level and output (which we interpret as a downward-sloping demand curve).

• The introduction of the labour market (including the wage rate) and firms, who use labour to help produce output. We demonstrate that profit-maximisation on the part of firms implies that more will be produced as the price level rises (which we interpret as an upward-sloping supply curve).

• Argue that the final equilibrium is where supply equals demand.

Finally, we can perform “comparative static” exercises, using our model to see what happens when, for example, the government raises taxes or lowers the interest rate.

© stephen hall, imperial college londonpage 1 economic environment lecture 1 joint honours 2003/4...

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